The Dollar and Commodities - Just Friends

The recent, aggressive
ECB ease, combined with some mild Fed growls about increasing rates "at
some point," ought to be good news for the dollar against the Euro. And so
it has been, although as you see in this weekly chart (source: Bloomberg)
the weakening of the Euro has been (a) mild and (b) started more than a month
before the ECB actually took action. (Note that the units here are dollars
per Euro).

Even though the ECB did considerably more than expected, much of that was
in the form of a promise; until the body takes concrete steps towards implementing
some of the new QE forms, the decline in the Euro is likely to be relatively
slow and steady. Similarly, although the Yen has stopped weakening in 2014,
I expect that trend has further to go as long as the Bank of Japan doesn't
lose its nerve with easing. In any event, both of those central banks seem
at the moment to be more dovish than the Fed, which augurs for dollar strength.

Is that bad for commodities? The conventional wisdom is that since many commodities
trade in dollars, a strong dollar implies weak commodities and vice versa.

There is some support for this view. The chart below (source: Bloomberg)
shows weekly levels of the dollar index versus the DJ-UBS index, going back
to 1996 or so. The correlation is okay, at -0.725.

Note, though, that this is a correlation of levels. If you look at
a correlation of changes, which is what you would need to use dollar
movements as a trading model for commodities, it is effectively zero. (These
two series aren't lovers, moving together always, but just friends coming together
to the same place from time to time). Moreover, the regression of levels says
that commodities are currently 15% or so cheap - the red smudge on the chart
shows the current levels (yet another way that commodities appear to be cheap).
Finally, the beta is quite low: if the dollar index rose 20%, it would correlate
with roughly a 20% decline in commodities...if commodities preserved the same
level of cheapness. To be sure, that is a sizeable drop but a 20% rise in the
dollar would put it at levels not seen in more than a decade.

In any event, be careful not to confuse the nominal dollar price of commodities
with the real price (I've made this argument from time to time in many contexts
- see for example here, here,
and here).
Although changing the value of the dollar will diminish the price of commodities
in dollars relative to what they would otherwise would be, if the global
price level rises then the price of commodities will rise with it - they just
may rise less than they otherwise would. And, since commodities typically experience
their highest inflation "beta" at the beginning of an increase in inflation,
it is reasonable to expect that commodities' rise will be enough to cause any
dollar-inspired softness to be completely obscured.

You still want to be long commodities if we are in an inflationary upswing,
regardless of what the Fed does. And, needless to say, I am somewhat skeptical
that the Fed will do anything particularly aggressive on the tightening
side!

You can follow me @inflation_guy!

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Michael Ashton is Managing Principal at Enduring
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Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist,
and salesman during a 20-year Wall Street career that included tours of duty
at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation
derivatives markets and is widely viewed as a premier subject matter expert
on inflation products and inflation trading. While at Barclays, he traded
the first interbank U.S. CPI swaps. He was primarily responsible for the creation
of the CPI Futures contract that the Chicago Mercantile Exchange listed in
February 2004 and was the lead market maker for that contract. Mr. Ashton
has written extensively about the use of inflation-indexed products for hedging
real exposures, including papers and book chapters on "Inflation and Commodities," "The
Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven
Investment For Individuals." He frequently speaks in front of professional
and retail audiences, both large and small. He runs the Inflation-Indexed
Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes
for client distribution and more recently for wider public dissemination.
Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University
in 1990 and was awarded his CFA charter in 2001.